By The Way, Earnings Don't Have To Drop For The Market To Crash

As everyone wonders whether last week's market drop will develop into a full-blown "correction" — or a crash — here's something to consider:

Earnings don't have to drop for the market to tank.

One of the arguments you hear from those who scoff at the idea that stocks will drop is that, even though corporate profit margins are at record highs, they see nothing that would cause margins—and, thus, earnings—to fall. This argument ignores the fact that investors rarely see what will cause earnings or stocks to drop ahead of time. Only in hindsight are such "catalysts" screamingly obvious.

More importantly, this argument ignores the fact that earnings don't need to fall for stocks to to drop.

“Abrupt market weakness is generally the result of low risk premiums being pressed higher. There need not be any collapse in earnings for a deep market decline to occur. The stock market dropped by half in 1973-74 even while S&P 500 earnings grew by over 50%. The 1987 crash was associated with no loss in earnings. Fundamentals don't have to change overnight. There is in fact zero correlation between year-over-year changes in earnings and year-over-year changes in the S&P 500. Rather, low and expanding risk premiums are at the root of nearly every abrupt market loss. One of the best indications of the speculative willingness of investors is the ‘uniformity’ of positive market action across a broad range of internals. Probably the most important aspect of last week's decline was the decisive negative shift in these measures.”

In 2007, of course, the market plunge was followed by a collapse in corporate earnings. But the drop wasn't visible until after stocks had begun to fall.

Historically-informed investors are being given a hint of advance warning here, in the form of a strenuously overvalued market that now demonstrates a clear breakdown in internals. We observe these breakdowns in the form of surging credit spreads (junk bond yields versus Treasury yields of similar maturity), weakness in small capitalization stocks, and other measures. These divergences have actually been building for months, but rather quietly. Note, for example, that as the S&P 500 pushed to new highs in recent weeks, cumulative advances less declines among NYSE stocks failed to confirm those highs, while junk bond prices were already deteriorating. We don’t take any single divergence as serious in itself, but the accumulation of divergences in recent weeks should not be ignored. Notably, the majority of NYSE stocks are now below their respective 200-day moving averages (which again, isn’t serious in itself, but feeds into a larger syndrome of internal breakdowns in a market that remains strenuously overvalued).

Combined with the 1) extreme valuations and 2) Fed tightening we have written about frequently in recent months, it means that, if you're not considering the possibility of a major market drop, you're probably making the same mistake that investors often make: Assuming that, because something hasn't happened in the past few years, it can't or won't happen.